Bonds: Frequently Asked Questions
A bond is a loan you make to a government or a company. In return, the issuer promises to pay interest and to return your principal on a set date. Here are answers to common questions about how bonds work.
How do bonds pay me?
Most bonds pay interest, called the coupon, at regular intervals, and repay the face value at maturity. Some, such as zero-coupon bonds, pay no periodic interest and are sold at a discount instead, with the full face value paid at maturity.
Why do bond prices change?
Bond prices move opposite to interest rates. When market rates rise, existing bonds that pay lower rates become less attractive and their prices fall; when rates drop, they rise. If you hold a bond to maturity you receive the face value regardless, assuming the issuer pays, but if you sell early you may get more or less than you paid.
What are the main risks?
- Interest-rate risk: prices fall when rates rise, and longer-term bonds are more sensitive.
- Credit risk: the issuer may fail to pay. Ratings agencies grade issuers to help investors compare this risk.
- Inflation risk: fixed payments buy less if prices rise.
- Call risk: some bonds can be repaid early by the issuer, often when rates have dropped.
What kinds of bonds are there?
Common types include U.S. Treasury securities, corporate bonds, municipal bonds issued by state and local governments, and mortgage-related bonds. Each has different risk and tax characteristics.
How is bond interest taxed?
Interest on corporate bonds is generally taxable by both federal and state governments. Treasury interest is generally subject to federal tax but exempt from state income tax. Interest on many municipal bonds is exempt from federal tax, and may be exempt from state tax if you live in the issuing state. A tax-exempt yield is not automatically better, so compare it with taxable yields based on your own tax bracket.
Should I buy individual bonds or a bond fund?
Individual bonds offer a known maturity date. Bond funds offer diversification and easy access, but they have no maturity date, and their value fluctuates. Check the fees, since they can reduce your income.
What role do bonds play in a portfolio?
Bonds often provide income and can steady a portfolio when stocks are volatile. How much you hold should reflect your goals and time horizon.
To understand how bond income fits into your return, contact our office.
This article is general information, not tax, legal or investment advice for your specific situation.